These Stocks are Producing Mountains of Cash

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Depending on whom you ask, the current stock market is either too expensive and headed for a further fall, or too cheap and poised for a rebound. The issue is irrelevant. The real question involves specific stocks -- not the broader market. This is because, in these challenging times, some can look vulnerable, while others look like once-in-a-decade bargains.

I had no idea how cheap many stocks had become until I ran a screen seeking out strong free cash flow yielders. These are companies that look inexpensive in relation to their underlying free cash flow (which is what's left over after you deduct capital expenditures from operating cash flow ). To get the yield , you simply divide the trailing free cash flow by the company's enterprise value (market value plus debt minus total cash).

Historically speaking, blue-chip stocks often trade for 20 to 25 times trailing free cash flow. This translates into a free cash flow yield of 4% or 5% (i.e. 100/25 = 4). With the exception of the swoon of 2008/2009, we are looking at the only time in the past 40 years when a large number of blue chips actually sport free cash flow yields of 10% or more. In fact, 77 companies in the S&P 500 trade at such unusually low valuations, with 31 of them sporting free cash flow yields of 14% or higher. This is pretty amazing in an era when traditional "yield plays" such as bonds and certificates of deposit ( CDs ) offer yields below 3%.

Each of the companies in the table below sport free cash flow yields above 20%.

Of course, free cash flow looked pretty impressive for many companies in 2010, but it might suffer in 2011 and 2012 if theeconomy falls intorecession . So I've pared the list of high free cash flow yielders to exclude any company that saw a sharp drop in free cash flow in 2008 or 2009. Deeply cyclical companies are unlikely to attract value investors -- at least until we have a clearer read that a weak economy won't pressure cash flows anew.

Each of the companies in the table below trade for less than eight times "trough" free cash flow (i.e. the worst free cash flow showing in any of the past four years). This translates into free cash flow yields in excess of 12.5%.



Notably, there's no thematic trend with this group. You have struggling retailers such as The Gap (NYSE: GPS ) , beleaguered publishers like Gannett (NYSE: GCI ) and technology giants such as Dell (Nasdaq: DELL ) and Cisco Systems (Nasdaq: CSCO ) .  All of these firms have been hard-pressed to boost sales in recent years (which explain why theirshares have been so cheap) but in fact, they are all free cash flow powerhouses.

But some of these stocks face real long-term threats. Western Digital (NYSE: WDC ) , for example, may see its sales slide when traditional hard disk drives (HDDs) lose market share to newer forms of computer storage. As I noted recently , Micron Technology (NYSE: MU ) and Sandisk (Nasdaq: SNDK ) would be the clear beneficiaries of such a transition.

The rain-or-shinebusiness model
It's an old axiom that advertising is a very cyclical industry . But it may not be as cyclical as you think. Interpublic (NYSE: IPG ) , one of the world's largest advertising agencies, still managed to generate $446 million in free cash flow in 2009, less than the $700 million it bagged in 2008 and 2010, but still quite respectable. However, fears that the weak economy could lead free cash flow to evaporate have pushed this stock down 37% in just six weeks. Shares now trade at an eye-popping five times trailing free cash flow (good for a 19% free cash flow yield).

Even if results weaken to 2009 levels, shares would still trade for a hefty 12% free cash flow. And this would be a yield reflected at the bottom of the economic cycle. Imagine what this yield would look like when the economy is on a stronger plane.

Much of the credit for the free cash flow generation at Interpublic goes to a deep restructuring of the business that began in 2006. From 2003 to 2005, Interpublic looked ill-equipped to address changing client needs in an increasingly digital universe. So management sought out new ventures and acquired hotter young ad agencies while trimming costs. Earnings before interest, taxes, depreciation and amortization ( EBITDA ) margins were flat in the middle of the decade, rose to 3% in 2006, 8% in 2007 and about 10% in 2008.

What about a slowdown? "The advertising model benefits from high variable costs and we think IPG can maintain earnings and cash flow at current levels in a recessionary dip," note analysts at Albert Fried, who have a $13 share price target -- 30% above current levels.

And what is Interpublic doing with all of its free cash flow? It's supporting a dividend that currently yields 3%, while buying back stock ($140 million in the first half of 2011). The analysts at Albert Fried say those stock-boosting moves will continue: "IPG also has plenty of fire power to fuel share repurchases as the company has $1.8 billion in cash on its balance sheet and a stake in Facebook that can be monetized in the $200-$300 million range."

Risks to consider: Interpublic's free cash flow remained healthy through the 2008-2009 downturn, but a steeper and more sustained slowdown in the U.S. and European economies could push free cash flow closer to break-even.

Action to Take --> Forget the major stock averages. Instead, stay focused on cheap and defensive blue chips. These free cash flow generators are likely to be ports in the storm, especially since many of them are buying back stock with their prodigious free cash flow. Interpublic is just one place to look, but there are many more candidates out there.


-- David Sterman

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Investing Ideas

Referenced Stocks: DELL , IPG , MU , SNDK , WDC

David Sterman

David Sterman

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